Leiden Law Blog

Who or what regulates the regulators and regulated in a complex financial society?

Who or what regulates the regulators and regulated in a complex financial society? Photo: Irreducible Complexity, by Kip Pasta

Complexity science crosses borders of different disciplines because systems show remarkable resemblance. A lot of items can be modeled as a complex adaptive system: the brain, the economy, technologies, organisms, markets, firms and legal systems. A complex adaptive system contains many interacting elements that can generate (emergent) large scale behaviour. Most systems evolve over time and become more complex. Our society is much more complex than a century ago; due to digitalisation, specialisation, modularity, hierarchy, diversity, modifications and connections.

Robert Wright (2000) launched a stimulating idea that history is a non-zero sum game. (Human) history is a process of reaping increasing returns. Trust and communication are important aspects in an exchange economy in which we are “led by an invisible hand to promote an end which was not part of our intentions”. This is the famous quote of Adam Smith. In fact Smith is the first complexity thinker; economic science is founded on (assumed positive) external effects. However regularly crises, bubbles and depressions occur - especially in financial markets and institutions. Uncertainty and systematic risks can be detrimental to societies. What do regulators have to offer in preventing these movements? Is there an optimum level of law (and numbers of lawyers)? Is the law of increasing and diminishing returns applicable to additional regulations?  What are the revenues and costs of all these efforts? Are we pushing regulations too far? In a complex world we need more basic rules, we cannot control everything and prevent new crises.

Exchange societies need trust and communication: accounting and financial institutions and markets can contribute to that. Disclosure and financial regulations facilitate cooperation and exchange. An economic society needs law – in fact it co-evolves with law. But there is an important difference: in the private sector “success breeds failure”, but in the public (legislator) sector “failure is success” (DiLorenzo). Failure, fraud, crises and bubbles call for new regulations to restore transparency and trust. Markets sometimes overreact, but do legislators and regulators fall into the same trap? Money and language are basic requirements in our society but so are accounting (as a business language), and financial markets. But the regulations are growing in detail, sophistication and fragmentation due to the same forces that created our complex society. Usually the perception is that something happened because the market is unregulated. In fact financial markets are heavily regulated already.

Palmrose (2009) states that “current accounting has become too difficult for users to understand, too difficult for preparers to apply, and too difficult for constituents to audit, analyze and regulate”. There are 7 inconvenient truths about accounting: they are clustered around the complexity problem.  We have lost sight of the basic conceptions. Sarbanes-Oxley (SOX), IFRS and FAS regulations are fragmented, specific, detailed, duplicative, outdated and inconsistent. Of course lobbying influences this. Maybe accountants, instead of being the guardians of order, have become a source of complexity.  Does transparency increase when we do not know what we have measured?

Financial markets are a recursive system of interconnected decisions, theories, strategies, actions and expectations that lead to booms and busts (Pollock, 2012). It is impossible to control the systemic risks of the financial ecosystem. During the 1990s regulators drew three lessons: expand securitisation of mortgages, use mark-to-market accounting and risk-based capital requirements. These all contributed significantly to the housing bubble. Federal Reserve Chairman Ben Bernanke was asked: “how can you regulate systemic risk when you are the systemic risk”. In the 1990s markets disciplined corporations, nowadays regulators try to discipline the market, but who disciplines the regulators?

Regulators and regulated: be aware of complexity, go back to the basics. So do not try to do something about the following (especially during holidays) complaint: “And I wonder, still I wonder who’ll stop the rain.”

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